Netflix shares soar as profit climbs

DavidB. Wilkerson

SAN FRANCISCO (MarketWatch) -- Netflix Inc. shares rose more than 15% after the market closed Monday after the company said its second-quarter profit nearly doubled on increased subscriptions to its service, and that it remains on pace to achieve profitability in 2005.

Netflix
NFLX, -2.29%
said it earned $5.7 million, or 9 cents a share, compared with a profit of $2.9 million, or 4 cents a share, in the same period last year.

The company previously had forecast a loss in the range of $2.2 million to $7.2 million. Instead, it was able to record a profit, thanks to lower-than-expected marketing costs, better-than-expected cost management and lower-than-expected stock-based compensation expense.

Excluding stock-based-compensation expenses, Netflix would have earned $9.1 million, or 14 cents a share, in the latest period.

Revenue rose 37% to $164.5 million.

Analysts polled by Thomson First Call were expecting a profit of 1 cent a share on $163.5 million in revenue.

The stock was up $2.97 to $19.63 in after-hours trading.

Netflix is benefiting from a series of trends, Chief Executive Reed Hastings told analysts during a conference call.

"Adams Media Research now estimates that by 2010 there will be 15 million online rental subscribers, which suggests that we're still early in the growth cycle and the potential may be greater than any of us imagined," Hastings said.

"This year, 90 million U.S. households will pay for either cable or satellite TV," he went on. "This means that there are 90 million households in the United States willing to pay for subscription entertainment, and that gives us a very large, addressable market."

Hastings' optimism about the DVD rental market comes at a time when there are rampant concerns throughout the entertainment industry that demand for sales of the discs is slowing.

Netflix says it remains on track to start trials of its Internet movie download service by the end of this year.

"As I've said in the past, we expect downloading to attract only modest consumer interest initially, primarily due to the lack of content availability," Hastings said. "The content, rather than the technology, will be the gating factor, but in the meantime, of course, we'll keep growing our DVD subscriber base and we'll continue to invest 1-2% of revenues on downloading to ensure we're ready when content availability and pricing makes it compelling to consumers."

Subscribers rose 53% to 3.196 million by the end of the second quarter, in line with the company's forecast of a range between 3.065 million and 3.265 million. Churn, or the rate of subscriber cancellations, declined to 4.7% from 5.6%, and its subscriber-acquisition cost was $37.25 per gross subscriber addition, compared with $35.12 for the year-ago quarter and $37.89 in the first quarter of this year.

"We spent less in online and TV [advertising] than we expected to," Barry McCarthy, Netflix's chief financial officer, said during the call. "We were too conservative in our assumptions about what things were going to cost, and the yield from various initiatives. So ... given our strong performance in Q2, we should have spent more on marketing and grown even faster."

Derek Brown, an analyst at Pacific Growth Equities in San Francisco, expected a subscriber-acquisition cost of $40.50 per subscriber, with a churn rate of 4.9%.

Hastings said the company's recently implemented $9.99-per-month plan that lets users take out one disc at a time has "resonated" with consumers. Its basic subscription price remains $17.99 for as many DVDs as a customer wants, in exchange for the right to take out up to three movies at any one time. The company has a library that includes more than 50,000 titles.

When the company raised its subscription price at one point last year, from $19.99 to $21.99, churn went up, Hastings pointed out, and when it cut its basic subscription price to $17.99, cancellations declined. "Price is a major value, a major driver," he said.

Netflix said that it expects to generate revenue in the range of $172.5 million to $176.5 million in the third quarter and that it will end the period with a subscriber total in the range of 3.35 million to 3.5 million.

In the fourth quarter, Netflix expects to post revenue of $187 million to $193 million, ending the quarter with 3.85 million to 4.05 million, it said.

For the full year, the company now predicts profitability, having earlier foreseen a loss. It lifted its full-year revenue forecast to a range of between $678.1 million and $688.1 million, up from an earlier target of $660 million to $685 million.

In May, retail giant Wal-Mart
WMT, -1.58%
said it was abandoning its own DVD rental service to partner with Netflix.

Since it entered the U.K. online DVD rental market last year, there has been widespread circulation that Amazon would soon enter the U.S. market, perhaps with a service priced as low at $13.99 for rental of up to six DVDs a month.

"[A]s time goes by and our competitive position strengthens, Amazon's
AMZN, -1.80%
direct entry into the market seems both less formidable and less likely," Hastings said. "With our volume of 1 million shipments per day, we can make money at price points no new entrants can.

"Any new competitor can have small losses and small results, such as Amazon's U.K. on-line rental business, or they can suffer huge losses in an attempt to get to scale quickly."

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